Groping for a Bottom?

T here are lean years and fat years. And sometimes there are years with just a little meat on the bone. This might be one of those years for the commodities markets. That essentially means prices may stabilize. Not rally, necessarily, but find a bottom as excess supplies are drawn down and capacity is cut.

If so, it would be good news to commodity producers and to the stock market if fears of deflation wane. But it may be bad news for commodity-trading advisers, since perhaps 90% of them are trend followers. Prices are not so important in themselves, but they have to move to provide trading opportunities.

In 1998 the markets' decidedly bearish price patterns proved a windfall for many commodity funds "and so we are seeing more interest today in these funds than ever before," says Aspen Partners' Ken Banwart, who allocates $400 million to commodity traders. But if markets move in a range in '99, making money may be tougher than it was in '98. "If it is a sideways trend, that's the worst environment for commodity traders to be in," says Banwart. "They need volatility."

That may be all but absent in some markets, notably precious metals. Gold, now $288 an ounce, may gain only 4% to average $300 an ounce, says Doug Cohen at Morgan Stanley Dean Witter. This past year, gold demonstrated it is a mere commodity by failing repeatedly to rally during '98's numerous crises. Financial collapses, impeachment and air raids were unable to overcome poor supply-demand fundamentals. That won't change with the advent of the euro; the new European Central Bank poses a psychological threat to the market as investors fear more sales.

In silver, now $5 an ounce, Todd Hinrichs at ABN AMRO says the price gain will be negligible. Crucial Indian demand is price sensitive. Digital cameras may cut into silver's industrial use by the photography industry and Hinrichs sees new production coming on stream.

Crude oil, which plunged in '98, could have some volatility and a nice bounce. Traders may see prices jump 30% from current levels to average $15 a barrel in '99. But the upside is capped even if cold weather persists in the Northern Hemisphere this winter and if Asian demand resurges. There is just too much available capacity to sustain any more gains.

But crude still looks more attractive than gasoline, which today commands 35 cents a gallon, and heating oil, which fetches 33 cents a gallon. The product gluts show no sign of ending. Just last week, despite cold Northeast weather, distillate stocks actually jumped instead of declining, in part because of early restarts of refinery runs after planned maintenance. So refinery utilization actually is increasing, to 96.8% of capacity from 94.5%.

Natural gas, now at $1.85 a million cubic feet, looks more positive in '99. Bill Featherston at Schroders expects prices to jump 19% to average $2.20, in part because there have been no agreements to shutter supplies in this market. Gas also is much more a North American commodity than a global one like oil. And despite robust drilling, which has increased by 20% a year since '96, production remains flat. Technology has made it easier to tap wells efficiently, but it hasn't made it easier to find gas.

Thus, though prices were hit by last winter's mild weather, 1998's warm fall and a drop in industrial demand for items like petrochemicals, many of which are sold to Asia, natural-gas companies don't have a lot of excess capacity. Moreover, since these companies are debt-heavy, they've suffered severe cash-flow shortages, forcing drilling for new wells to drop materially. Should the weather normalize and huge inventories get drawn down, prices could rally in the second half.

Some stocks in the energy sector that Featherston likes include:
Devon Energy
and Burlington Resources. Both companies have strong balance sheets and the majority of their reserves are in natural gas, making them sensitive to moves in that commodity's price.

In base metals, a leader in the commodity decline of '98, there may not be much mettle in '99. Overcapacity and global economic weakness are likely to continue to weigh on prices, pushing down copper, aluminum, nickel, zinc and lead perhaps another 10%.

For equity investors, while other sectors hit by deflation have seen merger activity, there hasn't been much here. That's likely to be a key theme in '99, as companies struggle to boost profits amid continued low prices. Possible acquirers, say analysts, include Anglo-American, Billiton PLC and Rio Tinto.

Overall, if the markets maintain supply-side discipline in '99, they may be well situated to rally in 2000. That would make for a Happy New Year.

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